Portfolio Diversification 101: Why It’s Important To Diversify Your Investments

“Diversification” is probably one of the first terms you see whenever you read about strategies for smart investing. But are you clear on exactly what it means to have a diversified portfolio and why you should care?
Diversification Defined
Diversifying your investments simply means making sure all of your money isn’t in just one financial “basket”. Instead of investing in a single security, diversified investors put their money into a variety of different stocks, bonds, mutual funds and exchange-traded funds (ETFs).
The idea is that if one of your investments goes down in value, there’s a good chance that another investment will go up in value. In this way, diversification helps you keep your financial life in balance. Diversifying may help you earn a little more on your investments, but the greater value is that diversifying helps reduce your risk of losing money.
What Kinds of Investments Make Up a Diversified Portfolio?
There are many different ways to diversify your money. The most basic type of diversification is by asset class. For example, your investments might be comprised of 70% equities (investments in stocks) and 30% bonds (fixed-income-type investments). The exact diversification approach you use will depend on your time horizon—when you’ll need to withdraw your money—and your risk tolerance.
You can also diversify your investments using a mix of other factors:
Geography: You could invest in both U.S.-based and international funds. Within your international funds, you could diversify further by investing in both established financial markets and less-developed countries (known as “emerging markets”).
Investment style: One mutual fund or ETF might focus on investing in stocks or funds that are currently undervalued—a strategy known as value investing. Another fund might focus on investing in companies that have a consistently strong earnings record. Owning a mix of funds that adhere to different investment strategies is another way to add diversification to your portfolio.
Company size: In the investment world, companies are placed into different stock groupings based on their market value. Companies with a very high market value are considered “large-cap” companies, mid-range companies are “mid-caps”, and lower-valued companies are “small-cap” firms. When you diversify your portfolio by company value, you might invest in a mix of large-, mid- and small-cap stocks or stock funds.
Industry sector: Well-diversified investors ensure that their money is spread over a number of different parts of the economy, such as health care, technology, manufacturing and so on. Why? When one industry is lagging, chances are good that another industry is steadily earning.
How do I make sure my portfolio is well diversified?
Mutual funds and ETFs already have a certain amount of diversification baked into them because they invest in a range of companies. In addition, these funds clearly lay out their investment strategies—including their diversification priorities—in their prospectuses. Finally, each fund’s name usually includes a clue about their strategy. For instance, it might be called the Acme Emerging Markets Bond Fund or the Acme Small-Cap Stock Fund.
It can be tough to diversify your portfolio on your own. Some investors diversify too broadly, which can limit their ability to outperform the market. A Financial Advisor can help you optimize your portfolio to achieve the right level of diversification as part of a strategy that is based on your risk tolerance, time horizon and individual goals.
Brian Jacobs is a Executive Director, Wealth Advisor in Valencia, CA at Morgan Stanley Smith Barney LLC (“Morgan Stanley”). He can be reached by email at brian.jacobs@morganstanley.com or by telephone at (661-290-2022). Brian P. Jacobs may only transact business, follow-up with individualized responses, or render personalized investment advice for compensation, in states where he is registered or excluded or exempted from registration,
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